China
Should We Be Worried About Large Minimum Wage Hikes?
June 08, 2010

By Qing Wang | Hong Kong & Steven Zhang | Shanghai

Headlines: Large Minimum Wage Hikes across Country

A number of local governments in China recently announced rather large minimum wage hikes. Based on the public announcements of minimum wage hikes by 11 provinces, the average increase of minimum wage hike is 17%, ranging from 5% in Hunan province to 27% in Ningxia province. It is widely expected that many other provincial governments will soon follow suit. These developments have helped create a perception that labor costs in China are surging, which in turn would lead to strong upward pressure on inflation and downward pressures on corporate margins.

Facts: Belated Adjustments

The seemingly coordinated and synchronized hikes of minimum wages by local governments are encouraged by the central authorities and have, in part, reflected the suspension of minimum adjustment in late 2008.

According to the Ministry of Human Resources and Social Security, during the decade of 1994-2004, minimum wages were raised by about 3.8 times by the provincial governments. Since 2004, local governments in China have been required by central authorities to adjust the minimum wage at least every other year. This policy has proven effective: during the nearly three-year period between April 2004 and 2006, minimum wages were raised by an average 1.9 times.

However, the Ministry of Human Resources and Social Security issued a policy notice on November 17, 2008, calling for temporary suspension of minimum wage adjustments, as part of the policy package to cope with the global financial turmoil and Great recession. As a result, few local governments across the country - including those provinces that are scheduled to raise minimum wages in 2009 - raised the minimum wages in 2009. Therefore, for a vast majority of provinces, the current round of minimum wage hikes would be the first hike over the last two years or even longer. Moreover, due to the suspension in 2009, the timing of minimum wage hikes among provinces has become more synchronized: provinces that were scheduled to make the adjustment in 2009 postponed the move to 2010, and this coincides with the adjustment by these provinces, which are scheduled to do so even in the absence of the suspension in 2009.

Reality: Pace Not Excessive; Level Not High

Despite the seemingly large minimum wage hikes, it should not be treated as leading to broad-based wage pressures or substantial erosion of low labor cost competitiveness in China, in our view. This is because the magnitudes of minimum wage adjustments lag the average wage and nominal GDP growth by a wide margin. The latest round of rather large minimum wage adjustment has, in part, reflected the need to make up for the no adjustment in 2009, in our view.

For instance, while Ningxia province has registered the highest average minimum wage hike of 27% among all the provinces reported so far, the cumulative GDP growth during 2008-09 was a whopping 60% and the average wage growth during 2007-08 was 45%. Shanghai has the highest level of minimum wage in China. Despite a 17% hike in the minimum wage, average wage growth during 2006-08 was twice as fast as the minimum wage increase.

The ratio of minimum wage to average wage is typically used as an indicator of the appropriateness of minimum wages. According to a World Bank study, minimum wage can be categorized as ‘low', ‘modest', ‘medium high', ‘high', and ‘very high' based on cross-country practices.

According to the World Bank study, as a rule of thumb, in developing countries - where the ratios tend to be higher - the national minimum wage should be less than 40% of the average wage. In this regard, the country average ratio of minimum wage to average wage is 32% in China. Specifically, about two-thirds of provinces belong to the ‘medium high' category, about one-quarter of the provinces belong to the ‘modest' or ‘low' categories, and only two provinces belong to the ‘high' category. And given that average wage growth seems to have outpaced minimum wage growth in recent years, the ratios of minimum wage to average wage in many provinces may have declined.

Compared to other economies in the region, while the current levels of minimum wage in major Chinese cities are not low, they do not look particularly high either. Specifically, major cities in the three most advanced economies in the region - Japan, Korea and Taiwan - stand out as having much higher minimum wage levels than the rest of the region. While Chinese top-tiered cities - including Shanghai, Beijing, Shenzhen, Tianjin and Guangzhou - have higher minimum wages than major cities in the rest of developing Asian countries, the minimum wages in Tier 2 cities in China - including Qingdao, Shenyang and Dalian - seem comparable to the average minimum wage levels in major cities of developing Asian countries, excluding China. Of note, more advanced small open city economies like Singapore and Hong Kong do not stipulate minimum wage, which is in line with the best practice predicted by the theoretical literature: imposing minimum wages in small open economies would make these economies quickly lose competitiveness.

Impact: Macro versus Sectoral

The minimum wage hike is unlikely to cause significant inflationary pressure at the macro level over the next 6-12 months. Despite the seemingly large minimum wage hikes, we maintain our long-standing call for a benign inflation outlook in 2010 and expect inflation to peak in June/July and average inflation to be around 3.2% (see China Economics: Goldilocks on Track: Taking Stock of 1Q10 Developments, April 16, 2010). And in view of the recent decline of international commodities prices, the balance of risk to this forecast is tilted to the downside, in our view.

Inflation is ultimately a monetary phenomenon and has little to do with minimum wage adjustment in theory. Moreover, while minimum wage increase may generate inflationary impulse, whether it can translate into meaningful cost-push inflationary pressures hinges on its impact on unit labor costs, which is a function of both average nominal wage increase and labor productively growth. We estimate that the growth of industrial unit labor costs (ULC) has declined after peaking in 3Q08 and may have dipped into negative territory towards end-2009 (note: relevant data are available through 3Q09). While the ULC may have again resumed positive growth since early 2010 in line with CPI reflation, the resulting inflation pressures have proved to be quite manageable thus far.

To the extent that minimum wage increases signify broad-based upward pressures on labor costs, the attendant impact would vary substantially across different sectors in the economy, depending on the labor intensity of each sector. The higher compensation for labor in the cost structure is, the larger the potential negative impact.

We rank the shares of labor compensation in per unit output for 42 sectors that cover the entire economy to help gauge the relative impact between sectors stemming from wage pressures. Not surprisingly, labor-intensive sectors such as agricultural and various services could potentially be most affected by wage increases. On the other hand, capital-intensive heavy industries such as electric machinery manufacturing, smelting and rolling metals and manufacturing of machinery and equipment are among sectors that would likely be least affected.

Implications: Labor Market Normalization Underway

We caution against overreaction to the rather large minimum wage hikes of late and suggest that one should take account of the historical context in which the recent minimum wage adjustment has been made, the continued rapid economic growth in China, the time-honored theoretical benchmark and the international and regional practices.

At the same time, we should not lose sight of the fact that labor market normalization has been underway for several years. The period of 2004-05 represents the beginning of the end of surplus labor supply in China, in our view. Since then, seasonal shortage of labor, especially in coastal areas (i.e., around Chinese New Year), has become the norm instead of the exception. Going forward, as labor market normalization continues, strong growth will be more often than not accompanied by wage pressures, in our view.

That said, running out of extremely cheap labor is not a sign of economic weakness in general and does not necessarily represent the beginning of the end of strong economic growth in particular. Specifically, successful economic development in China over the last three decades, aided by a large pool of surplus labor, has translated into a large pool of national savings, which is key to sustaining strong growth in China (see China Economics: The Virtue of ‘Over-Saving': A Post-Crisis Reflection on Chinese Economy, September 27, 2009). This is the fundamental reason why we remain constructive on China's medium- and long-term economic outlook.

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Hungary
Hungary: Much Ado About Nothing?
June 08, 2010

By Pasquale Diana | London

Two weeks ago, we had noted with concern that early commentary from Fidesz representatives were a concrete risk that the transition to a new government would not be market-friendly. In particular, we worried about the attack on the NBH governor, the change in the rhetoric on the euro and confusing statements about FX loans and the conversion of those into local currency loans. Last week's events proved far worse than our worst fears. A series of communication blunders left investors incredibly confused, recreating some of the panic that prevailed in late 2008 and early 2009. In this piece, we revisit last week's events, assess whether there was any logic at all behind what happened, and offer our views on what they mean for risks to HUF and interest rates.

To Hell, and Back...What Happened?

Hungarian markets were rattled and the HUF sold off sharply late last week on the back of some unfortunate comments by senior Fidesz politicians. On Thursday night, Mr Kosa, Fidesz Deputy Chairman, compared Hungary to Greece ("Hungary has only a slim chance to avoid the Greek situation"). Then, Deputy PM Varga said that a deficit of 7.0-7.5% of GDP is realistic for this year (the official target is 3.8%), without offering any details. On Friday, Szijjarto (PM spokesperson) was quoted by Bloomberg as saying that default talk was not an exaggeration (though other agencies reported softer comments).

Clearly, this was a lot for the markets to take, especially given the extremely nervous risk backdrop: the HUF ended the week 5% weaker versus the EUR and 8% weaker against the USD; 5-year CDS spreads widened by around 150bp, to just over 400bp; and 5-year bond yields widened by 100bp. CHF/HUF, the FX cross that matters most to all households who borrowed in FX the equivalent of around €20 billion, is close to its crisis levels. And the list goes on. Essentially, every single risk indicator that the NBH watches flashed danger.

Deputy PM Varga's comments on Saturday sought to restore some sanity and calm markets. He admitted that the recent comments by government officials were "unfortunate" and talks on Thursday and Friday about finances were "exaggerated" - in essence, he backtracked. He added that the previous government left behind a worse fiscal situation than reported, that expenditure items were not included and that revenue targets are also out of reach. Importantly, however, he said that the government will try to aim to meet the 3.8% of GDP deficit. The government will meet the IMF in the coming days, but these will be informal talks, not a review, said Varga. He added that the cabinet plans to release its report and its decision late on Monday or early Tuesday.

The Background: The Fiscal Audit and Fidesz's Tax Plans

To be sure, the 7.5% number that rattled markets is not new: Fidesz members had mentioned it several times in the past as a risk. And we had highlighted many times that Fidesz would seek to negotiate a higher 2010 target with the IMF (from the current 3.8% to 5.0-5.5%). However, what seemed different this time is that we knew that Fidesz is close to revealing the results of its fiscal audit, in which all the previous government's alleged ‘fiscal skeletons' would be revealed. Thus, the 7.5% went from being just a risk case (markets were braced for 5-5.5%, we think) to a new working assumption. The lack of colour, followed by added commentary on potential default, certainly did not help.

So, why did Fidesz officials first scare markets and then backtrack so quickly, reassuring investors that they will work within the IMF framework and try to stick to the fiscal targets? It is of course possible that this is just a huge PR disaster, a clumsy attempt at discrediting the previous government which took HUF assets and markets with it, as a nasty side-effect. Alternatively, it is possible that officials are trying to distance themselves as much as possible from the previous administration, and want to blame delaying tax cuts or approving painful saving measures on the fiscal legacy of the Socialist government. We will find out more when the decisions are announced, later today or tomorrow.

How Much Slippage in 2010? NBH Says 3% of GDP at Most

The NBH research department undertakes serious analyses on the fiscal numbers, and it published an instructive report in its May Inflation Report. Its central forecast is for a deficit of 4.3-4.5% of GDP this year (ESA deficit). But the NBH also identifies several sources of slippage, mostly from off-balance sheet items:

•           First, the debt of the state-owned transport companies (MAV, BKV, Malev). The bank estimates that their total debt may reach 1.5% of GDP by end-2010.

•           Second, carryover balances. These are sort of ‘reserve funds' which are usually around 1.5% of GDP. However, because of recent expenditure restraint, they are well above 2% of GDP. Therefore, bringing them back to more normal levels could increase the deficit by 0.7-1.0% of GDP.

•           Third, local governments. Here, the NBH admits that the risks are very difficult to quantify, but the risk that the government has to step in and service its debt is estimated at 0.3% of GDP.

•           Fourth, healthcare sector debt. This is estimated at 0.2% of GDP.

Therefore, the slippage could be at most 3.0% of GDP in 2010, says the NBH. This would take us to an ESA 95 deficit of at most 7.5% of GDP (curiously, in line with Fidesz's ‘bad scenario'). However, one needs to be careful. First, we know nothing about the maturity of these debts, but there is no reason to assume that they will all be assumed and paid off this year. More likely, they will be distributed over a few years, to lessen the impact. Also, note that the above items do not necessarily imply higher issuance: the government has cash balances at the NBH which it can use to service this debt; also, items such as the ‘carryover balance' represent money which is already available. Therefore, drawing on this sum may increase ESA95, but would not increase the cash deficit and the borrowing needs, we think.

In terms of issuance needs in 2010, our strategists argue that Hungary's external issuance (US$2 billion of 10-year bonds) already covers the redemptions of two bonds maturing in July (US$300 million JPY Samurai bond) and September (€1 billion eurobond) - unless borrowing needs increase sharply, Hungary should be funded for the year on the external front. And in terms of local debt, the AKK has so far issued HUF 570 billion of bonds compared to a full-year plan of HUF 1,356 billion, leaving HUF 786 billion of issuance over the remaining seven months, or HUF 112 billion per month. So far, this is broadly in line with what it has issued (two HUF 50 billion auctions per month), so seems doable to us. Hungary also has HUF 1,200 billion of T-bills. Our strategists think that rollover issues should not be material, unless the worst case scenario of market collapse and IMF/EU aid suspension (very unlikely, in our view) plays out.

What Are the Dangers of a Suspension of the IMF Programme?

The success of the IMF package has been key in limiting Hungary's external vulnerability. The front-loaded programme was extended by six months to October 2010. So far, the IMF has disbursed around €9 billion out of €12.5 billion available, and Hungary even chose not to withdraw the December tranche. The next tranche (June) should be around €800 million. The EU has disbursed €5.5 billion out of €6.5 billion of its assistance programme. World Bank money is available (€1 billion) but has not been used yet. We estimate that a sizeable portion of the drawn funds still sit at the NBH and were not used to fund the deficit: FX cash reserves are now €30.6 billion, massively higher than pre-IMF programme (€17 billion). These look ample, and should serve to dispel any notion that Hungary could experience a liquidity crisis this year or even next.

Overall, the IMF programme has been a success and Hungary's compliance has been widely praised. The risks around the budget exist, but we think that the likelihood of a suspension is very low. Any indication that the Fund is thinking of suspending or withdrawing assistance would trigger speculation that weaker programmes (Romania) may suffer the same fate. Therefore, there is a limit to how tough the IMF can be on Hungary.

On the NBH, Intervention Levels and Monetary Policy

While some retracement of last week's losses looks likely to us as Fidesz changes its tone, the HUF remains vulnerable, we think, especially given the weak risk appetite we expect over the next quarter or so. We think that the NBH will not dare to cut rates as long as there is this much uncertainty. For a long time, the bank took the macro outlook as a given: core inflation was slowing, growth was weak and the output gap was getting larger, pushing down medium-term inflation. Therefore, provided the risk environment was favourable and the currency strong, the NBH would continue to ease monetary conditions via lower rates, as the macro outlook suggested it should. In months in which the risk indicators (CDS, HUF, bond yields) suggested a particularly favourable risk backdrop, the NBH even cut by 50bp.

Clearly, the risk environment has changed a lot, reducing the NBH's scope of action to nil in the near term. Importantly, the bank also faces a much less favourable CPI outlook: the update of the inflation projection shows that the medium-term CPI forecast was revised higher (as expected), mostly due to higher energy price assumptions, and the outlook for growth was also marked up modestly. The inflation projection now shows headline CPI stuck at around 4% later this year, and then heading to around 3% (the target) in 2011, and a touch below in 2012. The previous forecast showed inflation falling to 2% next year.

Currency-wise, we think that HUF remains vulnerable here and would not rule out NBH intervention to cap the upside in EUR/HUF. Previous experience shows that speed of moves matters as much as actual levels. There are no magic numbers, but we suspect that the NBH would try and cap EUR/HUF rising above 290, especially if it gets there very fast. In terms of policy moves, the risk backdrop has changed so much that it is likely that the easing bias will be abandoned at one of the upcoming meetings, we think, barring a significant improvement in sentiment. An emergency rate hike (at least 100bp) is unlikely, we think, barring a sharp move higher in EUR/HUF to above 300 which happens so precipitously to give the clear impression that a rout is likely.

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Euroland
The Mediterranean Diet: Too Harsh for EMU Health?
June 08, 2010

By Daniele Antonucci & Elga Bartsch | London

Summary and Conclusions

Like the other major economies, the euro area is now expanding again. However, the looming fiscal tightening is a potential threat to the fragile recovery. In this report, we take a close look at the current and prospective fiscal austerity programmes of the euro area member countries. We conclude that the overall fiscal tightening of 0.6% of GDP this year and up to 1.5% next year would reduce euro area GDP by 0.4% this year and up to 1% the next. However, the euro depreciation will likely offset in full the negative impact of fiscal austerity.

The effects will differ in each euro area country. We recently revised up our GDP growth forecasts for Germany, Italy and Portugal (2010), down for Spain, Greece, France and Portugal (2011). For the euro area as a whole, we maintain our below-consensus forecast of 0.9% this year and 1.1% the next. But despite no change in the overall GDP numbers, domestic demand might be even more sluggish, and exports stronger - courtesy of the combined effect of a weaker currency and further belt-tightening.

What Has Already Changed in the Fiscal Landscape?

There is virtually no correlation between the budget balance and GDP growth. So changes in the fiscal policy stance don't matter in the euro area? We think that they do matter a great deal, but not necessarily in a mechanistic sense. Indeed, measures of public sector activity - ranging from government consumption to the broader aggregate of government spending (which includes transfers) and public investment - show a meaningful link with GDP growth.

The Public Sector - Is it a Key Economic Driver?

Government spending is a fairly small share of euro area GDP relative to, say, household spending or total investment. Indeed, in 2009 it accounted for approximately 21.5% of GDP in the euro area, up from 19.8% at the beginning of the decade. This compares with a weight of 58.2% for household spending last year, and 19.4% for total investment. (Exports and imports of goods and services account for 41% and 40.3% of euro area GDP, respectively, so the share of net exports - i.e., exports minus imports - is negligible.)

However, the relevance of government spending - and the role of the public sector more broadly - as an economic driver, either directly or indirectly, should not be underestimated. Indeed, government spending has always contributed positively to GDP growth over the past decade, unlike household consumption, investment and net trade. Since 2000, government spending has accounted for about one-third of euro area annual GDP growth of 1.4%, on average. Clearly, this looks set to change. With a more stringent public purse in many euro area countries, the chances are that government spending might even contribute negatively to GDP growth over the next couple of years. What's more, the public sector does affect the economy not only through changes in government spending. Other channels, from public investment to tax policy, are also important.

Direct and Indirect Effects - Are They Important?

Empirical evidence confirms that government involvement in economic activity does play a key role and can affect GDP growth - though in a counterintuitive way, in some instances. We explore various public sector-related indicators and look at their correlation with GDP growth for the euro area as a whole and its constituencies:

•           Government consumption, i.e., government spending which buys goods and services produced in the economy and which is not a transfer payment of money collected in taxation from one group in society to another. Government consumption counts towards GDP, while transfer payments take money from some people and give it to others. Most day-to-day health and education expenditure count as government consumption. Building new hospitals is government investment; old age pensions are a transfer payment.

•           Public investment, i.e., gross fixed capital formation of the general government - including, among other things, structures and equipment used by the military, which are similar to those utilised by civilian producers, such as docks, airfields, roads and hospitals; light weapons and armoured vehicles used by non-military units. The purchase of military weapons and their supporting systems is still part of intermediate consumption and not included in gross fixed capital formation.

•           Government spending, i.e., the sum of intermediate consumption, public investments and payments for compensation of employees, subsidies, social benefits and transfers, and tax-related disbursements, among other things.

Looking at the past 20 years or so, the evidence suggests that government consumption, and, to a lesser degree, public investment are positively correlated with economic growth.

Conversely, overall government spending is negatively correlated with economic growth. Although this may seem counterintuitive at first sight, one explanation could be that, in periods of weak economic activity or recessions, government spending tends to increase - courtesy of the functioning of the so-called automatic stabilisers (such as unemployment benefits), which are quite substantial in several euro area countries.

Similarly, economic growth is adversely affected by an increase in government revenue (i.e., receivables on taxes, transfers, subsidies and contributions, as well as other sources - such as privatisation receipts - to help finance spending) as a share of GDP. For example, a tax hike will exert a negative impact on growth - all else being equal. In this case, too, the inverse correlation seems fairly high - at least over the 1992-2009 period under examination - just like with government spending.

Austerity Underway - Not Just in the Iberian Economies

So, changes in the fiscal policy levers do have a non-negligible impact on economic activity. With all countries in the euro area set to cut their budget deficits over the next couple of years, this will undoubtedly exert a negative effect on GDP growth. However, not all will implement their belt-tightening programmes simultaneously. Apart from Ireland (the first mover on the fiscal tightening scene back in 2008), some have already started. After Greece - see Our First Assessment of Greece's Loan and Austerity Package, May 3, 2010 - it is now the turn of Spain, Portugal and Italy. Others are likely to follow shortly, we think (France, and - perhaps further down the line - the Netherlands and Belgium). Some (notably Germany) will use their extra fiscal leeway to implement a more gradual adjustment programme. In particular, only the so-called EMU periphery has tightened (or is about to tighten) the belt this year - at least so far:

•           In Spain, the new extra savings amount to €15 billion in 2010-11. This is equivalent to about 0.5% of GDP this year and 1% next year. Measures include: abolition of ‘birth payment' of €2,500 per household, 5% cut in civil servants' wages this year and a wage freeze next year, elimination of 13,000 public sector jobs, suspension of index-linked pensions in 2011, and spending cuts at the regional level. Factoring in the announced savings into our forecasts, we now expect the budget deficit at 9.4% of GDP this year and 6.7% the next (see Spain Economics: Extra Fiscal Tightening - In Small Steps, May 12, 2010). What's more, further fiscal austerity measures look likely, in our view, on three fronts: 1) a new wealth tax will likely apply to individuals with net worth greater than €1 million - subject to parliamentary approval; 2) further income tax rate hikes seem on the cards; and 3) a ban on local councils from issuing long-term debt - previously planned for this year - will take effect in 2011.

•           In Portugal, the new extra savings amount to approximately 1.2% of GDP in 2010 and 2.2% in 2011. Apart from bringing forward the phasing-out of all the anti-crisis stimulus measures and some tightening planned for next year, measures include: cuts in central government spending, lower transfers to local governments and state-owned enterprises, 5% wage reduction to holders of political and public management offices, introduction of motorway tolls, increase of 1pp up to the 3rd income bracket and an increase of 1.5pp for the 4th income bracket onwards of personal income tax, and a 2.5pp increase in the corporate income tax for taxable profits exceeding €2 million. Factoring in the announced savings into our forecasts, we now expect the budget deficit at 7.5% of GDP this year and 4.7% the next.

•           In Italy, the Combined Report on the Economy and Public Finance (known as RUEF in Italian), published in May, had already mentioned that the government would have needed to tighten its primary budget by about 1.6% of GDP over 2011-12, in order to meet the fiscal targets mentioned in Italy's latest stability programme submitted to the European Commission - to which it reiterated full commitment. In its present form, the resulting €24 billion package will include: 1) a three-year freeze on state wages; 2) pay cut for top public sector workers; 3) extra measures to curb tax evasion; and 4) delayed retirement for those due to retire next year. Factoring in an extra belt-tightening of the above-mentioned magnitude into our forecasts, we now expect the budget deficit at 5.1% of GDP this year and 3.7% the next.

How Much More Tightening Is Needed?

It all depends on what ‘how much' really means. Given the very different starting positions, the amount of consolidation required will vary significantly by country. The IMF has estimated the adjustment needed between 2010 and 2020 to bring the debt below 60% of GDP by 2030. According to these estimates, the cumulative required adjustment varies from around 4% of GDP in Germany and Italy to about 8% in France and Portugal, and 9% in Greece and Spain (see Fiscal Monitor - World Economic and Financial Surveys, May 14, 2010). And the variation in the adjustment needed to meet the Stability and Growth Pact's 3% ceiling for government borrowing might be even larger, as suggested by the annual reduction in the structural primary deficit that the European Commission believes is necessary to bring the unadjusted deficit below 3% of GDP before its deadlines.

Where Might the Extra Squeeze Come From?

The various EMU members will have different preferences in terms of the spending categories that could eventually be trimmed. Ireland spends more than average on healthcare, education (together with Portugal) and environment, housing and recreation, Italy on general public services, Greece on defence and economic affairs, Germany on social protection, and Spain on public order and safety.

What's more, further job reductions in the public sector might be considered in some countries, as was the case in Spain and Greece recently. Alternatively, there might be further hiring freezes in the public sector, or the introduction of, say, 2:1 rules of retirements/recruitments. On this front, France is the country with the highest share of workers in the public sector (36%); at the other end of the range there's Portugal (25%).

Post-Election Tightening in the Benelux Countries...

Fiscal consolidation has so far taken a backseat in the Netherlands and Belgium. This postponement reflects, at least in part, the fall of both governments in February and April, respectively - along with the difficulty, in both countries, to form a new ruling coalition. In particular:

•           In the Netherlands, the election campaign is still in full swing, with the vote scheduled for June 9. Traditionally, fiscal policy has ranked quite high among the various governments' priorities, and the country has sound - and well deserved - credentials in terms of fiscal consolidation. Although the situation remains fluid on the political front and the magnitude of an eventual tightening may depend on the outcome of the election, a report by the Netherlands Bureau for Economic Policy Analysis (known as CPB in Dutch) shows that the political parties' programmes encompass cutbacks in government spending and, in most cases, increases in the tax burden.

•           In Belgium, the vote is scheduled for June 13. Although the budget deficit is not particularly wide (around 6% of GDP in 2009), a triple-digit debt/GDP ratio of approximately 100% might well translate into market worries from a long-term fiscal sustainability standpoint. The election outcome will likely affect the fiscal policy outlook, at least to some degree, in this country too. But this will have to do mainly with the intensity of the belt-tightening, which looks very much on the cards regardless of the outcome of the election.

...While Germany Can Afford to Wait a Little Longer

Being in a stronger fiscal position relative to most European countries - and courtesy of its solid reputation as a fiscally responsible country - Germany has more time to cut its relatively contained budget deficit. And its benchmark status in euro area bond markets does imply more leeway on the fiscal front. But the fiscal policy stance is shifting in Germany too, we think. Not only has the government already postponed its previously announced tax cuts, it is about to hold an offsite (ending on June 7) to discuss budget savings for next year (probably around €10 billion).

France?

Harsh fiscal austerity doesn't seem to be on the cards - at least not at this stage. This sets France apart from virtually all the other euro area members. But its fiscal policy stance too is shifting - albeit somewhat more gradually than elsewhere - courtesy of the sovereign debt crisis, we think. While it's mainly the EMU periphery that has so far been under the market spotlight, France could be affected too at some point - should concerns spread to core countries. Indeed, the government has recently announced that, in order to achieve the goal of cutting the budget deficit to less than 3% of GDP in 2013, it will freeze nominal government spending (excluding interest payments and pensions) over the next three years. But future attempts to replenish the state coffers - which we deem to be very likely - might well entail changes in the current tax breaks and, possibly (but more difficult in the short term), the pension system.

What's the Impact on GDP Growth?

Different Country, Different Policy

Sooner or later, then, we expect all the major euro area economies to go through a period of fiscal tightening. But just what impact will that have? The effects of government policy will depend on a wide variety of factors, not least the types of policy pursued by each government. Analysis based on previous periods of fiscal consolidation, including work by the OECD and IMF, suggests that income tax hikes are particularly harmful as they discourage work. Government spending cuts are thought to do less damage because they can lead to efficiency improvements. Of course, the fact that there is scope to pursue certain policies does not mean this is what governments will do, and the likely method of consolidation remains highly uncertain. On the face of it, though, a given degree of belt-tightening might be quite damaging in Greece, Ireland and Spain, due to tax hikes. Germany and France might fare a bit better, given that income taxes are unlikely to rise in the former and spending could easily be cut - to various degrees - in the latter.

The Fiscal Multiplier - A Short Review

The actual impact on aggregate demand needs not coincide with the amount of fiscal tightening. Indeed, there is no consensus in the academic literature on the so-called fiscal multiplier. For example, the OECD Interlink model (see Dalsgaard et al., 2001) has a multiplier equal to 1.2 for government spending, i.e., a cut in government spending of 1pp of GDP reduces euro area GDP by 1.2% over one year relative to the baseline - the effect, according to this model, is stronger in Germany and weaker in France, with Italy's response in between.

Similarly, a tax hike has a multiplier equal to -0.5, i.e., a hike in income taxes of 1pp of GDP reduces euro area GDP by 0.5% over one year relative to the baseline. The more recent OECD global model (see Hervé et al., 2010), however, finds a more moderate impact on GDP from a cut in government spending, to the tune of 0.8%. The various models in use at the European central banks, including the ECB's area-wide model, suggest that a cut in government spending of 1pp of GDP typically reduces GDP by 0.8-1.2%, depending on the member country (see Fagan and Morgan, 2005).

With fiscal policy being a key economic driver, the features of the INSEE MZE-2003 model might come in quite handy, because the published documentation explicitly mentions quarterly multipliers for government spending, as well as direct and indirect taxes (see Beffy et al., 2003). The INSEE MZE-2003 model has a multiplier equal to 0.9 for government spending, i.e., a cut in government spending of 1ppt of GDP reduces euro area GDP by 0.9% over one year relative to the baseline. The multiplier for income taxes is -0.3, while that for indirect taxes is -0.7.

So, How Much of an Impact on GDP?

The academic literature offers no conclusive guidance on the impact of changes in the fiscal policy stance on the economy. For example, while there seems to be a somewhat broader consensus on the effects on the US economy, namely that spending cuts have a smaller impact on GDP than tax hikes, the evidence for the euro area looks mixed. For example, the INSEE MZE-2003 model indicates that government spending exerts bigger effects on the economy than changes in the tax regime. But we don't necessarily subscribe to that view in full.

Although details are not fully known in many cases, it seems that about half of the additional fiscal tightening in 2011 will take the form of spending cuts for the euro area as a whole. The remaining half will revolve around increases in income taxes and VAT rate hikes, as well as higher taxes on gasoline, alcohol and tobacco, among other things. For our calculations, we strike a balance between the responses to the various types of tightening suggested by the models and the information available on the actual policy mix, applying a good dose of our own judgment and experience too.

We use a fiscal multiplier equal to 0.7, i.e., the extra fiscal tightening announced for 2010 (worth about 0.2% of GDP) and for 2011 (worth about 0.5% of GDP) would reduce euro area GDP by about 0.1% this year and 0.4% the next. The overall fiscal tightening of 0.6% of GDP this year and 1.2% next year (in part already factored into our forecasts) would reduce euro area GDP by 0.4% this year and 0.8% the next. With France and the Benelux countries likely to tighten their belts too in the second half of this year, some of the EMU peripherals to step up their fiscal consolidation efforts and Germany to follow at some point, the chances are that the full impact on GDP of the extra austerity measures will rise from our current estimate of 0.4% to at least 0.6% in 2011.

The Euro - How Much of an Offset?

Having reached our 1.24 target in EUR/USD, we now expect a decline to 1.16 by year-end. We see further weakness in 1H11 - when we expect EUR/USD at 1.12 - and we have changed our end-2011 target from 1.36 to 1.17 (see FX Pulse - A Bigger Rise in the Dollar, May 27, 2010). From an export perspective, however, it is not EUR/USD that matters, but the trade-weighted (TW) exchange rate. Why? Because the US is not the only euro area trading partner, just an important one. The UK is more important, as are Central and Eastern Europe as a whole and Asia, for example.

The euro has declined by about 12% on a trade-weighted basis since the peak in October 26, 2009, and by around 9.5% year-to-date. We expect it to drop by another 6.5% or so in the next 12 months. What's the boost to economic activity? In this case too, the answer from the various econometric models is ‘it depends on the assumptions', ranging from the characteristics of the theoretical model to the statistical method used to estimate it.

As a rule of thumb, however, we feel comfortable with our own calculations, i.e., a 10% depreciation in the trade-weighted exchange rate boosts GDP by approximately 0.7% over one year relative to the baseline - within the range of most central banks' and international institutions' models.

This means that the depreciation of 10% or so over the past 12 months would boost euro area GDP by 0.7% over the next 12 months, thus offsetting the overall fiscal tightening announced so far. What's more, we now expect the trade-weighted exchange rate to reach a cyclical low next May - corresponding to a depreciation of 20% from the peak in 3Q09. Should this happen, euro area exports would benefit in 2012 too, all else being equal.

Putting it All Together...

So it seems that the negative impact of the looming fiscal tightening will likely find an offset in the positive impact of a weaker euro. But even if the economic outlook for the euro area as a whole is unlikely to change sharply, the composition of growth will likely change, and the member countries will probably be affected to various degrees. We approach this theme from three perspectives:

1.         The 1Q GDP numbers have been more robust than expected in some countries, e.g., Germany (0.2%Q versus our forecast of zero growth), Italy (0.5%Q versus 0.3%Q) and Portugal (1%Q versus 0.2%Q); conversely, France disappointed (0.1%Q versus 0.2%Q, consensus was more optimistic at 0.3%Q). The annual average GDP growth rate is a weighted average of the quarterly growth rates. The individual quarters have a different impact on the annual average, with the first quarter having the biggest impact on the full annual number (see our Practitioner's Guide to European Macro Indicators, June 4, 2010). This means that, all else being equal, a stronger-than-expected first quarter might translate into meaningful upside risks to GDP growth.

2.         Although the effects of fiscal austerity and a weaker euro may offset each other for the euro area as a whole, this does not mean that all EMU countries will equally benefit or be penalised. Export-oriented economies will experience a greater boost to GDP growth from the euro depreciation (e.g., Ireland, Benelux, Germany and Austria). Conversely, the ‘fiscal sinners' will have to tighten their belts more aggressively than average, thus experiencing a greater drag on GDP growth (e.g., Greece, Ireland, Portugal and Spain).

3.         For the euro area as a whole, fiscal austerity and currency weakness will likely have a composition effect. Domestic demand, in particular household consumption, will probably turn out to be even weaker than currently envisaged - courtesy of the current and prospective tightening. Conversely, net exports might contribute to GDP growth to a greater extent, relative to our central forecast, if a depreciation of the magnitude expected above takes place. We illustrate how the composition of growth might change for a given rate of growth (our central forecast), factoring in both the fiscal austerity and euro weakness mentioned above. The upshot is that an export-led recovery looks the only favourable outcome for the euro area.

All Good Then?

No, not really. We reiterate our below-consensus call for euro area GDP growth both this year and the next. Basically, even in our central scenario the growth impulse will come mostly from net exports in 2010, and solely from net exports in 2011. Should the above-mentioned composition effect play out as we expect, i.e., stronger export contribution courtesy of the euro depreciation and weaker domestic demand contribution courtesy of ongoing fiscal austerity, the alternative scenario encompasses a recession on the domestic front next year.

What's more, the economic fallout of the banking crisis last year and the sovereign debt turmoil this year will be substantial, in our view. The growth rate of GDP is finally back in positive territory - and might even strengthen slightly in the short term. That's good news. But the level of GDP is still quite depressed. Indeed, we expect it to reach the 2008 peak no earlier than 2012. Apart from changes in the composition of growth, a weaker currency - or the degree of belt-tightening currently envisaged - is unlikely to change the outlook.

Of course, the euro depreciation may boost inflation over time. In turn, this might help nominal GDP recover. But even in this case we don't envisage much stronger growth, given the disinflationary pressures that fiscal austerity will exert on the domestic economy (after the initial inflationary impulse from indirect tax hikes). From this perspective, it might take until 2015 - at best - for Greece's and Ireland's GDP to go back to pre-crisis levels. Conversely, most other euro area countries might recover the lost ground by 2011, with the exception of Spain - which might take at least one more year.

Conclusions

In all, there are five main takeaways for financial markets:

•           With the so-called EMU periphery having already put in place various fiscal austerity programmes, and virtually all EMU countries expected to tighten their belts at some point, the belt-tightening - worth about 0.6% this year and up to 1.5% next year - will exert a negative impact on euro area GDP growth.

•           Based on our own calculations and on European Commission's recommendations, Germany, Italy, the Netherlands and Austria have less homework to do in terms of fiscal adjustment, while Greece, Ireland, Spain and Portugal will have to tighten their belts more aggressively than the ‘average' euro area country.

•           The overall fiscal tightening of 0.6% of GDP this year and up to 1.5% next year would reduce euro area GDP by about 0.4% this year and up to 1% the next. What's more, the euro depreciation of 10% or so over the past 12 months would boost euro area GDP by 0.7% over the next 12 months, thus offsetting the negative impact of the austerity measures. And the chances are that these gains will extend to 2012.

•           The effects will differ in each euro area country, depending on its fiscal plans, social preferences, trade openness and underlying economic strength. We recently revised up our GDP growth forecasts for Germany, Italy and Portugal (2010), down for Spain, Greece, France and Portugal (2011) (see European Eco Weekly - Policy, Politics & Minutes, May 14, 2010).

•           For the euro area as a whole, we maintain our below-consensus forecast of 0.9% this year and 1.1% the next - but the chances are that the composition of growth will be affected. Despite no change in the overall GDP numbers, domestic demand might be even more sluggish, and exports stronger - courtesy of the combined effect of a weaker currency and further fiscal austerity.

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United States
Review and Preview
June 08, 2010

By Ted Wieseman | New York

Investors in US markets were able to largely ignore the still-worsening situation in Europe for a couple days during the middle of the past week and focus on a run of strong domestic data as stabilization in dollar interbank markets suggested that European spillovers were being contained, sending Treasuries modestly lower.  But when the employment report disappointed what had apparently built up to excessively elevated expectations over the course of the week and the situation in Europe continued worsening on Friday - with Hungary suddenly becoming a focal point of debt concerns late in the week, Spain's yield spreads over Germany approaching new highs, the euro's sell-off sharply accelerating, and European bank stocks coming under severe pressure - Treasuries surged on the day to end the week with good 5-year-led gains.  The sudden emergence of Hungary on Friday as a new front in the European debt troubles marked the second Friday in a row in which European concerns seemed to be easing only to have surprising headlines throw markets into renewed turmoil - the Fitch downgrade of Spain the prior week and then, to start a much worse day this week, a spokesman for Hungary's government saying that talk about the risk of a Hungarian debt default was not "an exaggeration at all".  On the employment report, we had expected to see some moderation in underlying job growth in May compared to April, mostly as a result of weather swings, and that appears to have happened to a somewhat larger extent than we anticipated.  The weather was unusually good in April, and we think this might have added up to 100,000 to job growth at the expense of May.  The average ex-census job growth in April and May of 122,000 was somewhat softer than the +164,000 two-month average we were expecting, but we were quite encouraged by how strong the hours and earnings numbers were in May, and think they point to better jobs numbers ahead.  And other key initial May data released over the past week - both ISM surveys and early consumer spending indications from the run of sales results from auto companies and major retailers - plus the April construction spending numbers were also better than expected.  We are increasingly confident that the economy is showing a decent acceleration in 2Q towards +4% GDP growth from the +3% growth posted in 1Q - and with a much stronger mix of final demand versus inventories in the current quarter.  This will ultimately, of course, be important for markets but only when investors are convinced that the European turmoil is becoming less severe or at least that spillover impacts into other regions can be well contained.  The latter seemed to be the case for much of the past week, with US markets focusing on better domestic data while taking some comfort in particular from the stabilization in Libor and significant recent narrowing in forward Libor/OIS spreads.  But this was unsustainable without support from a blowout employment report in the face of the steady widening in Spain's spreads, swift broadening of the EU debt turmoil to Hungary, with echoes of the Greek experience as a spokesman for the new Hungarian government warned of major upward revisions to this year's deficit figures, claiming that economic numbers had been "falsified, manipulated, and lied about", and the intensifying slide in the euro. 

On the week, benchmark Treasury yields fell 6-12bp after rallying 10-19bp Friday to more than reverse modest losses posted through Thursday.  The 2-year yield declined 6bp to 0.72%, 3-year 9bp to 1.15%, 5-year 12bp to 1.98%, 7-year 11bp to 2.64%, 10-year 10bp to 3.19% and 30-year 10bp to 4.12%.  TIPS breakevens were similarly seeing some upside over the course of the week through Thursday but reversed back down hard in Friday's renewed fear trade that included big losses in commodity prices and a surge in the dollar, with July oil losing 4% on the week and the LME's base metals composite - which was soft all week on China slowdown fears even before Friday's global rout - 11%, while the dollar index surged 2%.  The dollar's biggest gain on the week was actually against the Australian dollar, which sank to $0.824 from $0.847, but the more headline-grabbing move clearly was the drop in the euro to another four-year low of $1.198 from $1.227, with two-thirds of that drop on Friday.  On the week, the 5-year TIPS yield fell 6bp to 0.29%, 10-year 4bp to 1.22% and 30-year 6bp to 1.75%.  This lowered the 10-year inflation breakeven 4bp for the week to 1.98% after an 11bp decline Friday.  Interest rate volatility actually didn't move much during Friday's big move in yields and ended the week little changed, which was supportive of another robust week for the MBS market.  Fannie 4% MBS was trading just below par at Friday's close, sending current coupon mortgage yields down to just above 4% after a small outperformance versus the week's Treasury market rally.  Average 30-year mortgage rates have been close to 4.8% the past three weeks, just above the record low of 4.71% reached in December, and if continued European fears in coming days allow Friday's rally to be sustained into the coming week, we could see a new low shortly.  Mortgage refinancings have been rising quite sharply recently, providing some rate stimulus to consumers from this financial crisis on top of some real income stimulus that has been provided by the big pullback in gasoline prices recently. 

After rising steadily from mid-March until late May, with the rate of increase accelerating sharply for a few weeks in May, 3-month Libor has been just about unchanged now for eight straight days, fixing Friday at 0.537%, effectively unchanged on the week.  This has left the spot 3-month Libor/OIS spread at 30 or 31bp consistently over this period.  While this is up 20bp from mid-April, we are not overly concerned considering that when the 2007-09 financial crisis first broke out in August 2007, the spot Libor/OIS spread was through 30bp immediately, was through 60bp within a week, was near 75bp at the end of August, and was moving towards 100bp by mid-September.  After that initial August 2007 blowup, the spread didn't even get back through 30bp again until July 2009, so if that's as bad as things get in dollar funding markets in this crisis, it's hard to see it as much of an issue.  What had been becoming increasingly more concerning than this spot spread a couple weeks ago was how much the market was pricing it would escalate in a fairly short period of time, apparently seeing some risk of an August/September 2007 situation developing over the summer even if the stresses are nowhere near that high now.  But while there was a bit of backtracking in the general renewed fear trade Friday, on the week there was still a modest further scaling back of these forward-funding worries.  As long as this key potential liquidity transmission mechanism remains contained, systemic spillover worries from the European situation eventually should calm again down to some extent, we would expect.  On the week, the forward Libor/OIS spread to September fell to 52bp from 55bp and the May 24 high of 71bp as the Sep 10 eurodollar contract rallied 5bp to 0.795%.

This was the second week in a row where risk markets tried to set aside European worries to post gains into Thursday only to be knocked back down by a renewal of fears Friday.  But there was a much worse downturn this Friday from the combined impact of the sudden situation in Hungary, steady widening in Spain/Germany spreads, and heavy pressure on European financials than there was the prior Friday from the ‘tape bomb' of Fitch's downgrade of Spain, which in retrospect was really immaterial.  On the week, the S&P 500 lost 2.2% after plunging 3.4% Friday.  In contrast to the stability in rates, equity market volatility shot up, with the VIX moving up to 35.5 from 32.1.  Credit was mixed, with investment grade performing quite poorly but high yield managing to outperform a bit on the week by not doing all that bad in the sell-off after having lagged while other risk markets had been doing better through Thursday.  The IG CDX index widened 9bp to 126bp, while the HY CDX index was about 40bp wider near 665bp.  Subprime and commercial real estate also held up better in Friday's sell-off after having done well through Thursday to end up with decent gains on the week - the AAA ABX index rose 2%, AAA CMBX 1%, junior AAA CMBX 2% and AA CMBX 4%.  The gradual move wider seen all week in peripheral European government debt spreads over Germany - which by Friday had the Spain/Germany 2-year spread near 230bp, not far from the early May peak of 240bp as Spain starts to look ahead to a heavy schedule of July debt redemptions - applied spillover pressure onto the muni bond MCDX market all week, and this intensified in Friday's big fear trade.  The 5-year MCDX index was up to 185bp Friday afternoon, 20bp wider on the week and through the prior wide for the year of 180bp reached in February.

The past week's economic data showed broad upside, including important underlying details of the employment report, notwithstanding the disappointing headline payroll number.  The key run of initial data for May - both ISM surveys, early indications of consumer in the auto and chain store sales results, and the robust hours and earnings numbers in the employment report - plus the biggest gain in construction spending in April in a decade indicated that the acceleration in the economy that became increasingly apparent in the underlying resilience in the February data despite the severe weather has extended well into 2Q.  Growth in 2Q looks set for a decent acceleration from the +3% recorded in 1Q, likely running near +4% overall and with much more robust underlying details than in 1Q, with the inventory contribution in 2Q likely to flatten out at least temporarily after accounting for half of 1Q's 3% growth. 

Non-farm payrolls surged 431,000 in May, but almost all of the gain reflected 411,000 temporary census hires (which will start to reverse in June).  Private sector job growth slowed to 41,000 after a 218,000 rise in April, with the volatility probably largely driven by the unusually good weather in April.  Weather can be quite important for jobs in April as seasonal industries ramp up, and the impact seemed apparent in swings in outdoor oriented sectors like construction - down 35,000 in May after a 14,000 rise in April - and leisure - up only 2,000 in May after a 35,000 jump in April.  Beneath this short-term weather-related volatility in payrolls, other key details of the report were strong.  The unemployment rate fell to 9.7% from 9.9%, but probably mostly from census impacts.  Hours and earnings numbers, which are private sector only, were also quite robust, however.  The average workweek rose a tenth to 34.2 hours, high since November 2008, which combined with the gain in private sector payroll lifted total private sector hours worked by a solid 0.3%.  With average hourly earnings accelerating to +0.3%, aggregate earnings - an important proxy for total wage and salary income - soared 0.7% on top of a 0.6% gain in April and 0.4% rise in March.  Note that with the recent seasonally unusual softness in gasoline prices, inflation will be weak in May, so that +0.7% number will be near +1% in real terms, and the +7% annualized surge in nominal aggregate payrolls over the past three months will be about the same, and a lot more impressive, after adjusting for flat prices in the three months through May.  Within the upside in overall hours worked, the manufacturing sector continued to lead.  Factory sector jobs rose 29,000, the average workweek jumped to 40.5 hours from 40.2, and aggregate hours worked jumped 1.1% - pointing to another very strong industrial production report in May. 

That factory sector strength in May had been previously seen in a surprisingly robust manufacturing ISM report after broad moderation in the regional surveys.  The composite manufacturing ISM index fell only fractionally to 59.7 in May from the six-year high of 60.4 hit in April, and underlying details were stronger, with all the pullback accounted for a drop in the inventories index, while orders (65.7 versus 65.7) and production (66.6 versus 66.9) held steady at unusually high levels and employment (59.8 versus 58.5) posted a further gain.  In addition to the disconnect from the main regional reports, however, some details suggested that this strength may have, to some extent, reflected a lag in fully reflecting recent developments.  In particular, the prices paid index was little changed at a very high level despite the pullback in commodity prices over the past month, and the export index hit a 22-year high, which was surprising given the turmoil in Europe.  Meanwhile, the composite non-manufacturing ISM index was steady at 55.4 in May, a high since 2006.  The breadth of the expansion improved though, with a record 16 of 18 sectors reporting growth, up from 13 in April and March.  The most notable shift among the components was a one-point gain in the employment index to 50.4, the first reading above the 50-breakeven level since December 2007.  The business activity gauge (61.1 versus 60.3) moved to a five-year high, but the orders index (57.1 versus 58.2) moderated a bit. 

In the upcoming week, investors seem likely to continue Friday's renewed focus on the European debt distress after the brief period of relief we had this past week.  The US calendar is fairly light, with Treasury market focus likely to be largely on supply until Friday's retail sales report.  The Treasury will auction $36 billion 3s, $20 billion 10s and $13 billion 30s on Tuesday, Wednesday and Thursday.  The 3-year size was cut $2 billion for a second-straight month, but the 10-year and 30-year reopening sizes were held steady, as the debt managers are extending the average maturity of coupon issuance even as they trim back overall coupon issuance modestly to allow a slowing in the rate of T-bill sector paydowns as the deficit starts to narrow.  Other than the retail sales report the most notable data releases are the trade balance and Treasury budget Thursday:

* We look for a slight narrowing in the trade deficit in May to $40.0 billion, with both exports (+1.6%) and imports (+1.0%) expected to post decent gains.  Export upside should be led by capital goods, with industry figures pointing to a sharp rebound in the volatile aircraft sector while factory shipment figures show strength in high-tech industries.  Higher prices should also support upside in industrial materials.  On the import side, higher prices and volumes point to some upside in petroleum products, while port data suggest that imports of other goods should also rise.

* We expect the federal government's budget deficit to narrow $57 billion from a year ago in May to $133 billion.  The swing reflects a number of factors, including: the special one-time $250 checks that were distributed to social security beneficiaries in May 2009 ($13 billion), lower TARP outlays ($12 billion), a calendar effect that accelerated some regular monthly payments into April (about $10 billion), and a quicker fall-off in tax refunds during the current filing season ($9 billion).  We continue to see the deficit tracking at $1.25 trillion (or -$8.5% of GDP) for the fiscal year as a whole.

* We look for a 0.4% rise in overall May retail sales and a 0.3% decline ex autos.  We see a number of cross-currents in the May sales data. First, due to differing seasonal factors, the modest rise in unit sales of motor vehicles appears to translate into a sizeable advance in the auto dealer component of retail sales (+3.5%).  Second, declining prices should lead to a significant drop in gas station receipts (-2.2%).  Third, sales at building materials outlets soared in recent months and much of this upside appeared to be attributable to the impact of the ‘cash for appliances' programs that were quite popular in many states.  Programs in most states wound down in April.  So, we look for a significant pullback in this sector (-4.0%).  The key item to watch in this report is retail control.  And, based on the mildly positive chain store results, we look for control to rise 0.4%.

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